Phantom Gain – When Your LOSS Becomes GAIN (1031 Exchanges) Tax Tips

Hi, David Moore, Equity Advantage, 1031exchange.com, and it is September 28th of 2022. And I think dates are important because we’re going to be talking about something called Phantom Gain today, and Phantom Gain is when gain is not profit. So I just want to stress out for our audience to understand that when you look at a 1031 exchange, it’s all based upon gain. Do you want to do an exchange? Do you not want to do an exchange?

I just got off the phone with somebody actually in Brazil wanting to do an exchange, and then talking about how much gain is going to justify that transaction, and I would say in today’s world, it’s going to need to be more gain to justify or rationalize a 1031 because we’re at a point where we don’t really know what’s happening with the economy and properties are maybe going down in value a little bit, the interest rates are climbing. We’ve got a lot of things going on.

So in recessionary times… Yes, I said it, a recession. If this was to be a recession, depending on your definition of one, you might be subjected to something called phantom gain, and Phantom gain’s one of those ugly things that comes up and bites you in the tail, and it’s because you think, “Well, gee, I lost something to short sale,” or, “I lost something to foreclosure. How could I possibly have a tax consequence?”

And once again, I want to say, gain has nothing to do with profit. Gain is simply a tax calculation. Gain is the difference between your adjusted sales price and your basis in a property. Your basis in the property is what you paid for it, plus capital improvements minus depreciation, and each of those items have little asterisks next to them, because if I say, well, what you paid for it, that definition of paid for means different things.

If I gifted you a property, your basis or that purchase price might be what my basis was. If you inherited a property from me, you got a stepped-up basis current market value. Again, we’re talking in September of 2022 when we still have stepped-up basis. And if you do exchanges throughout the years, you’ve got a basis carry forward; 1034, the old residential rollover, that’s a basis carry forward; 1033, involuntary conversion, that’s a basis carry forward. So depending on how you got that property, that initial purchase price could vary dramatically.

Then we look at capital improvements, and I do this every single day. I’m on the phone with people asking, “Okay, during the time you’ve owned this property, did you do any work to it? If so, what did you do and how did you treat it?” If you expensed those items, you wrote it off, if you capitalized it, it increases your basis. The third component there is depreciation. If you’ve got an income property, you’re renting it out, you should be taking depreciation. The government’s position, quite honestly, is, “Well, you should have taken it; therefore, you did.”

So if you’re not working with good tax people, you’re really sort of putting yourself in a handicap spot because you might be subjected to taxes for things you didn’t get the benefit of, and that’s what you pay good tax people for. While I’m on that topic, I’m just going to say I’m one member of a good, successful team of investment professionals. I’m going to put that tax person pretty much at the top. I think they’re very, very important. I’ll put myself on there, I’m going to put good, confident tax and legal people, obviously finance people, property managers, the brokers involved, good escrow people. Work with good people. You don’t have to know how to do everything. Just get in touch and work with people that do have the answers to the questions that you’ve got.

So what am I talking on and on about? Phantom gain. Phantom gain, you say, “Well, how could I possibly have tax exposure when I’ve lost this property, short sale, or foreclosure?” Well, on a primary residence, you’ve got some tax relief. On income properties, you don’t. So if we look at a short sale or a foreclosure, the government’s going to treat that debt on the property as the sales price, and if the debt exceeds your basis, that difference is the gain. So yes, unfortunately, it is possible to lose a property to foreclosure, have all your money evaporate and still have tax exposure.

So in recessionary times, fortunately, we haven’t seen these for a few years, we end up doing a number of transactions where we’re isolating our client from actual or constructive receipt of that phantom gain, and it’s a really pretty easy question to answer. If you’ve got the financial ability to go buy something, you may look at a situation where you lose the property to foreclosure, you’ve got tax on that, tax consequence on the delta between the debt and that basis, and you’re going to lose maybe a third of that to tax, well, if you go out and you buy something, what kind of loan-to value are you going to get? And you might be saying, “Well, gee, that debt, that foreclosure, that’s going to damage my credit.” And that’s quite possibly true.

We had a number of transactions up until probably 2018, cleaning up the mess from the last crash, where we had institutional investments going south. Those loans are non-recourse, so it didn’t damage my client’s ability to go out and get a loan to go buy something, but once again, the question is, “Do I want to just pay tax for the pleasure of losing everything or I don’t want to come out of pocket.” Roughly the same thing, maybe even less if you’re looking at 75% loan-to-value to go out and buy something through the exchange.

So again, you’re going to either come out of pocket to just pay for that loss through the phantom gain, or you come out of pocket roughly the same amount to go buy something. What would you rather do? Just pay the tax or get something out of it?

So once again, David Moore with Equity Advantage, and that’s just been a sort of a long-winded explanation of phantom gain and what you might be subjected to if you lost a property through foreclosure or a short sale, and as always, if you’ve got questions, please don’t hesitate to reach out. We’re happy to answer those questions. And if you’ve got an idea for a video that you’d like to see spelled out, let us know. David Moore, Equity Advantage, 1031exchange.com, and you can reach out to cmoore@1031exchange.com with any questions. Thank you. All my best. Take care. Bye.